Digging Your Own Mine

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If you've been caught in the old eight-hours-a-day grind for the last couple of decades, self-employment may sound like paradise. But of course there are responsibilities that go along with being out on your own. When you start your own business, you alone will be responsible for the paperwork that a big business pays a whole staff of accountants and bookkeepers to do. And, at least for the time being, you probably won't be able to afford full-time professional assistance. When you're at the helm, taxes are no longer an annual bother; they pop up at least every three months.

ARE YOU SELF-EMPLOYED?

Most trade, business, or sideline income, other than wages, is considered to be self-employment by the IRS. Exceptions to this include dividends and interest, capital gains, and rent from real estate for which you aren't a dealer and don't provide services to occupants (hotels, apartment buildings, etc., do produce self-employment income). If your self-employment income exceeds $400 per year, you're responsible for reporting it to the IRS as a self-employed person.

IS IT A BUSINESS OR HOBBY?

Demonstrating that you're in business to make a profit is crucial to your tax treatment by the IRS. If the IRS decides you're simply practicing a hobby, you'll not be allowed to deduct expenses that exceed income, you won't be allowed to deduct portions of bad debts owed to you, and you won't be able to apply for refund of prior taxes. (See the section "What if You Lose Your Shirt?") But how do you prove profit motive?

If you make money in two out of the first five years of business activity (seven years for raising horses for racing, breeding, or showing), the IRS will accept that you are in business to make a profit. If, however, at that point you fail to have had two profitable years, the IRS will disallow losses retroactively . . . you'll have to pay back any loss deductions you claimed in previous years, unless you can prove profit motive in a different way.

For example, you may still be able to deduct net losses—even without making a profit in two of five years—if you can demonstrate that you carried on in a businesslike manner (capable bookkeeping and management); had expertise in the activity; spent time and effort attempting to make a profit; had assets that were expected to appreciate in value; had been successful in similar ventures; had an expectation that such a business would be profitable; weren't openly attempting to shield other income; and/or weren't engaged in an activity from which you derived primarily recreational or pleasure benefit.